Gaming Activision

Video-game stocks are notoriously tough to play. Back in the 1990s, when you were able to talk to store associates in order to find out what consumers were buying, and could actually lay your eyes on inventories after the chat, it was much easier to get a grasp on the top- and bottom-line potential of the publishers. Nowadays, I wouldn't exactly call investing in a game-publisher a dart throw, but it has to be darn close to it, given the rapid evolution of the industry's business model.

Here's a quick synopsis:

● Games are pirated internationally, making prices for packaged goods very competitive. That is, the fact that XYZ publisher garners 40% of its sales overseas doesn't matter much if the profit margins are getting crushed.

● Once-hot online games, such as World of Warcraft, are now old news in terms of business models.

● Games on Facebook and handheld devices are in vogue. Still, an investor doesn't necessarily know what the profit margin is on a $9.99 game download or a $0.99 virtual pig purchase for Zynga's (ZNGA) Farmville. You might guess this is a meaty margin, but other virtual items and title downloads are competing intensely for discretionary dollars.

● Virtual worlds have been created to elongate the lifespan of packaged goods, such as expansion packs for Activision Blizzard's (ATVI) Call of Duty. Through this company's innovative, recently launched Call of Duty Elite, Activision Blizzard has developed a subscription-only virtual world for its best-in-class first-person-shooter-style game.

● In-game advertising monetization has not lived up to the hype of four years ago, but it's still contributing a nicely profitable revenue stream to the publishers.

● Entire games once made for the shelves in Best Buy (BBY) and Target (TGT) can now be downloaded online.

These are but a few of the obstacles to properly investing in a video-game publisher. Even if one does the rigorous analytical legwork on each of the elements outlined -- and that means visiting gamer chat rooms and video-game review sites -- there are likely to be many differing opinions on Wall Street. That's because all of the publishers have a good amount of sell-side analyst coverage.

In trying to beat a path through the brush, let's focus our efforts on the aspects we do know ahead of Activision Blizzard's earnings report this week:

● Amazon (AMZN) said its video-game business put in a subpar performance.

● THQ (THQI) warned and finally decided to exit its family/casual game business. (The Worst CEO Award of the Decade has to go to Brian Farrell of THQ.)

● ElectronicArts (ERTS) sold its case to the Street in the best way it could have possibly done. First, it said Battlefield 3 stole share in the first-person shooter category and, second, it claimed the launch of its self-hyped Star Wars: Old Republic online game was a hit. (That's a MMORPG for you hardcore gamers, or a massively multiplayer online role-playing game, for those unfamiliar.)

I believe we have to do some debunking here, and quickly. For one thing, I do not believe Electronic Arts' share gain came at the expense of Call of Duty: Modern Warfare 3. In its first five days of availability, that latter game registered $775 million in sales, up almost 20% year on year. Regarding Star Wars: Old Republic, the game did gain a subscriber base of close to 2 million people within 40-odd days of launch. However, this reflects mostly free signups. If this is a World of Warcraft killer, the real test will be whether these people begin to pay once their trial period elapses. So far, the verdict is out as far as that goes.

Regarding Activision Blizzard in particular, I've got mixed emotions on recommending this stock, as it has underperformed the broad-market rally in the past month. But that low-expectations hurdle may represent an opportunity, or least that's what I am hoping.

You see, Amazon's weak video-game sales were likely concentrated in older "catalog titles," not top-of-mind releases in Call of Duty: Modern Warfare 3. The Battlefield 3 share -- over which, again, Electronic Arts so triumphantly thumped its chest -- likely came at the expense of other first-person shooters in the marketplace. The sales numbers from that Call of Duty title don't support otherwise.

My view is that there are several fundamental reasons to be bullish on the stock, especially considering the stock's valuation (more on this below). First, the balance sheet of Activision Blizzard has more than $2 billion in cash. Second, the company has tight release plans -- it's focusing on fewer, better titles and virtual worlds. The Street is quite bearish on the World of Warcraft subscriber count after the 800,000 loss in the third quarter, though I would attribute this more to release timing of fresh content than to an impending demise of an industry stalwart.

The Setup on Activision Blizzard

● Analysts are underestimating the upside potential of the numbers from Call of Duty Elite and Skylanders for the holiday quarter.

● Estimates are too cautious on World of Warcraft subscriber count and the "share gain" by Battlefield 3 and the impact, if any, that it had on Call of Duty: Modern Warfare 3.

● Focusing on fewer titles and executing around big brands has been a winning strategy for Activision Blizzard in terms of generating consistent sales and profitability, unlike the boom-and-bust periods tossed on the board by competitors. That consistency is an intangible that's deserving of a nod in determining the valuation.

Earnings power is not being included in the stock valuation. Activision Blizzard's original 2011 earnings-per-share guidance was for $0.70 on a non-GAAP basis, and the company may go on to generate in excess of $0.86. Yet, the stock has gained a mere 5.5% in the last 52 weeks.

The market continues to be overly worried on peaking Call of Duty interest and the numbers into which that will translate. Also of too-heavy concern are challenging industry conditions, shifts to new game consumption platforms with uncertain profit margins and the first hints of a new console development cycle. That last item will require outlays in order to engineer the games technology to the new platforms.

However, Activision Blizzard's earnings stream quite simply shows these concerns to be unfounded for now, and it points to a richer-multiple valuation of 13x to 14x. That's also in light of strong industry positioning and a balance sheet that's likely to be tapped for another material share-repurchase plan in 2012.

If Activision Blizzard is able to put in a solid fourth-quarter EPS beat and in-line guidance for 2012, I would expect consensus earnings estimates to be hiked to a range of at least $1 to $1.05. I would also expect the stock to command a higher multiple -- that is, the stock price should climb toward its future projected earnings.

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